In a supplemental appropriations bill for FY 2018,[1] Governor Charlie Baker has proposed amendments to Massachusetts tax law that would deal with the two "hottest" issues on the state and local tax front nationally in the spring of 2018 – the impact at the state level of federal tax reform, and the implications of a pending decision on sales and use tax nexus in South Dakota v. Wayfair, Inc., which is now pending in the U.S. Supreme Court.[2]

Federal Reforms

The Baker package focuses primarily on the international aspects of the federal reforms included in what is commonly known as the Tax Cuts and Jobs Act ("TCJA"). Those reforms include three key provisions:

In transition from a system of "global" taxation of US companies to a modified territorial system, accumulated earnings and profits of controlled foreign subsidiaries were deemed repatriated under Subpart F of the Internal Revenue Code, for both individuals and domestic parent corporations, at the end of 2017.[3] This provision is called the "deemed repatriation." Deductions were allowed so as to tax the income at special, reduced rates.[4]

On a going-forward basis, TCJA provides for a new category of income of a controlled foreign corporation ("CFC"), known as Global Intangible Low Taxed Income ("GILTI"), that will be included in the tax base of the US owner of such a corporation.[5] GILTI income effectively is all income of a CFC that is not attributable to specified tangible property and is not already taxed as Subpart F income.[6] This provision is intended to encourage US companies to keep their income-producing intangibles in the United States. The GILTI regime also includes a deduction intended to reduce the effective tax rate on such income in the hands of US corporations.[7]

Also on a going-forward basis, domestic companies will pay a reduced effective rate of tax, via the mechanism of a deduction, on Foreign-Derived Intangible Income (“FDII”), which comprises certain income attributable to the sale of property to a non-US person for foreign use or the provision of services to a person or with respect to property outside the US.[8] This provision is also intended to curtail the outmigration of intangibles.

State Treatment of the Deemed Repatriation

Under the Baker Bill, for corporate taxpayers, the deemed repatriation amount would be treated as a dividend eligible for the 95% dividends-received deduction ("DRD") that applies generally to domestic or foreign dividends received or deemed received from a corporation in which the payee owns at least 15% of the voting stock.[9] For individual resident taxpayers, it would likewise be treated as a dividend that would be subject to tax, but the bill includes a 60% deduction applicable only to this category of income, in an attempt to closely mirror the federal reduced-rate treatment.[10]

The Massachusetts Department of Revenue ("DOR") estimates that its deemed repatriation regime will generate FY 2019 revenue of $65 million.[11]

State Treatment of GILTI

The state treatment of GILTI in general has been controversial. At the federal level, GILTI included in the income of corporations carries with it a foreign tax credit that in many instances will blunt or eliminate the adverse effect of this new provision. Neither Massachusetts nor the other states provide a credit for foreign taxes paid, so the GILTI impact on state taxes can be significant.

Further, many states are expected to tax GILTI without allowing any DRD, even if they generally apply a DRD to foreign dividends and to dividends deemed to have been paid under Subpart F. They may attempt to justify this treatment by reference to the fact that GILTI is treated like Subpart F income for some purposes, but is not Subpart F income in fact,[12] and also by reference to the fact that a corporation can have GILTI that exceeds the earnings and profits of the payor corporation.[13] On the other hand, failure to allow a DRD for GILTI invites a US constitutional challenge under Kraft v. Iowa Dept. of Rev.,[14] in which the US Supreme Court held that a separate return filing state that offered a DRD for domestic dividends could not deny the deduction for foreign dividends without violating the Commerce Clause.

The Baker Bill would eliminate such controversy in Massachusetts by providing that GILTI is deemed to be a dividend for purposes of the DRD (as well as for purposes of the rule that dividends are not included in the sales factor of the Massachusetts apportionment formula).[15]

For resident individuals, the bill provides that GILTI would be taxable as a dividend.[16]

DOR estimates that the GILTI provisions would generate $239 million in incremental revenue over the 10-year period from 2018 to 2027.[17]

State Treatment of FDII

The Baker Bill proposes to decouple Massachusetts from the FDII deduction.[18] DOR estimates that in the absence of such a decoupling the new deduction would cost Massachusetts $177 million over the same 10-year period.[19]

Treatment of Remote Sellers After Wayfair

On two occasions 25 years apart, the United States Supreme Court has held that remote sellers need not collect sales or use tax in states in which they do not have a "physical presence"[20] ("the Quill rule"). As Internet sales have become a bigger and bigger part of the overall economy, the states have grown concerned that the Quill rule is eroding sales and use tax revenues. Further, so-called "brick-and-mortar" retailers – those with stores in the states or other physical presence – have argued that the Quill rule creates a playing field that is not level vis a vis remote sellers.

Some states, including South Dakota, have reacted by mounting a direct challenge to the continued validity of the rule, arguing that the complexity of multi-jurisdictional compliance that underlay much of the reasoning of the Court in Quill has become a non-issue in practical terms because of advances in business technology. The South Dakota controversy was the first to reach the Supreme Court. Oral argument was heard on April 17, 2018, and questions from the justices suggested that the Court is very much divided on the question whether Quill should be overturned and, if so, what the collateral consequences of that should be.

Other states, including Massachusetts, have attempted to work around the Quill principle by arguing that notwithstanding Quill, many remote sellers can be required to collect because they have some form of physical presence in the state. In Massachusetts, such a physical presence (called "deemed nexus" elsewhere in this advisory) may include, according to DOR, "property interests in and/or the use of in-state software … and ancillary data (e.g., 'cookies') which are distributed to or stored on the computers or other physical communications devices of a vendor’s in-state customers."[21] Where such a physical presence exists, DOR requires collection by a remote seller if, during the preceding calendar year, it had in excess of $500,000 in Massachusetts sales from transactions completed over the Internet and it made sales resulting in a delivery into Massachusetts in 100 or more transactions.[22]

The Baker Bill would authorize DOR to create a special registration program for remote sellers having less than $500,000 in sales into Massachusetts in the previous 12 months, but having a physical presence in the state by virtue of tangible property maintained in the state by unrelated fulfillment providers or contacts related to remote Internet sales, including but not limited to the "cookie" nexus referenced above.[23] Qualifying sellers would be permitted to register for collection of sales and use tax on or before June 30, 2019 without incurring any liability for periods prior to registration.[24]

The sales and use tax provisions of the Baker Bill seem designed to create a relatively painless path forward for remote sellers in the event that the Supreme Court in Wayfair overturns Quill in such a way as to suggest that the states may chase remote sellers retroactively. The Baker Bill would protect many of such sellers from retroactive liability if their sales into Massachusetts are less than $500,000 and they register before July 1, 2019. Further, while it is not certain, it appears that DOR has no intention of going back before October of 2017 with respect to vendors over the $500,000 threshold whose contacts are limited to "deemed nexus," even if Wayfair holds that no physical presence is required to impose a collection responsibility.

Legislative Prospects; What Happens If the Bill Is Not Enacted?

It is difficult to predict what reception the Baker Bill will receive in the Massachusetts legislature. Because it comprises a supplemental appropriations bill, it has the "look and feel" of non-controversial "clean-up" legislation. It is not expected to give rise to concerted business opposition because some of its provisions, such as treating GILTI income as if it were Subpart F income and committing not to go retroactive with respect to smaller remote vendors who take advantage of the registration program, are relatively friendly to business interests. Further, it purports to raise significant revenue by virtue of provisions such as incorporating the taxation of GILTI in the hands of individuals, even though the GILTI regime was not in effect under the 2005 Internal Revenue Code that governs most Massachusetts individual taxation.[25] Finally, it must be said that the nuances of the federal reforms with which the bill deals will certainly not be understood by the legislators charged with passing on the bill. Taking all of these factors together, it seems likely that the bill, perhaps with material revisions, will indeed make it to the desk of Governor Baker for signature.

It is important to remember that, even if the Baker Bill dies on Beacon Hill, some of the approaches embodied in it are merely clarifications of what DOR intended to do even in the absence of legislative authorization. For example, DOR has already announced that its treatment of the deemed repatriation as dividends would give rise to $65 million in incremental revenue. And if the bill does not pass, DOR may consider itself to have administrative discretion nonetheless to adopt the registration program for small vendors.

[9] Baker Bill Section 10, by amendment of G.L. c. 63, s. 30. Because the DRD is allowed, the Baker Bill would decouple from the federal deductions that effectively reduce the rate of tax on the deemed repatriation for corporate taxpayers. Baker Bill Section 11, by amendment of G.L. c. 63, s. 30.

[11]See Administration and Finance Explanation of the Baker Bill. The TCJA permits taxpayers to elect to spread the tax on the deemed repatriation over eight years. IRC Sec. 965(h)(1). There is no such option at the Massachusetts level.

[15] Baker Bill Section 10, by amendment of G.L. c. 63, s. 30. As in the case of the deemed repatriation, Massachusetts would decouple from the federal deduction for GILTI on the grounds that allowing that deduction in addition to the state-level DRD would be duplicative. See Baker Bill Section 11, by amendment of G.L. c. 63, s. 30.